Can you still trust th­ese eco­nomic in­di­ca­tors?

The Pak Banker - - OPINION - Michael K. Farr

IT used to be that the bond mar­ket and com­mod­ity prices were some of the most re­li­able places to get a read on the fu­ture di­rec­tion of the U.S. econ­omy. Many stock in­vestors would in­crease their risk tol­er­ance as longer-term bond yields were ris­ing and re­duce risk as longer-term yields were fall­ing. The logic is fairly sim­ple: If eco­nomic growth rates are im­prov­ing, both com­po­nents of nom­i­nal in­ter­est rates - real rates and in­fla­tion - should be in­creas­ing as well. At the same time, the de­mand for goods and ser­vices gen­er­ally in­creases in an im­prov­ing econ­omy, putting up­ward pres­sure on the prices of those goods and ser­vices. The logic for us­ing com­mod­ity prices as a gauge is straight­for­ward as well: As­sum­ing sup­ply re­mains con­stant, grow­ing de­mand for com­modi­ties will re­sult in higher prices. As a re­sult, many in­vestors will look to the price trends in oil, cop­per, agri­cul­tural prod­ucts, pre­cious met­als, and many other com­modi­ties for signs of eco­nomic strength.

So why haven't th­ese two eco­nomic in­di­ca­tors worked dur­ing the course of this eco­nomic re­cov­ery? In­ter­est rates and com­mod­ity prices con­tinue to plum­met, de­spite U.S. eco­nomic data that, on the sur­face any­way, con­tinue to im­prove. What's dif­fer­ent this time? There's one ob­vi­ous an­swer: We now live in a global econ­omy.

The prices of money and com­modi­ties are not sim­ply a func­tion of U.S. de­mand but rather, they re­flect de­mand through­out an in­creas­ingly in­ter­con­nected world. Most no­tably, the rapid growth of the Chi­nese econ­omy in re­cent years has re­sulted in re­duced im­por­tance for the U.S. econ­omy. Twelve years ago, the U.S. ac­counted for about a third of global GDP, and that per­cent­age has fallen to about 22 per­cent. So for many years, a huge surge in de­mand for com­modi­ties in China drove the prices of oil, con­struc­tion ma­te­ri­als, and other com­modi­ties through the roof.

More re­cently, how­ever, growth in China has slowed while Ja­pan and Europe re­main in the dol­drums and the U.S. econ­omy mud­dles along at 2 per­cent to 2.5 per­cent growth rate. There­fore, some of the huge re­cent de­creases in com­mod­ity prices (while par­tially at­trib­ut­able to a pos­i­tive sup­ply shock in some cases) can be at­trib­uted to this weak­ness out­side of the U.S. The sec­ond, and per­haps more im­por­tant, rea­son for the dis­con­nect is cen­tral bank in­ter­fer­ence in the free mar­kets.

In the case of the mar­ket for money, the Fed­eral Re­serve has a di­rect ef­fect on the price of money, or in­ter­est rates. They have held the Fed funds rate near zero for sev­eral years, and they have ag­gres­sively bought longer-term Trea­sury bonds and mort­gage-backed se­cu­ri­ties so that yields on th­ese bonds would fall as well. By all ac­counts, the Fed was enor­mously suc­cess­ful in its mar­ket ma­nip­u­la­tion, tak­ing in­ter­est rates down to nearly un­prece­dented lows. Now that the Fed has wound down its quan­ti­ta­tive eas­ing, longer-term rates in the U.S. are still be­ing af­fected by mon­e­tary eas­ing - just not by the Fed.

The cen­tral banks of Ja­pan and Europe, while a bit be­hind the curve, are now putting the pedal to the metal. The spread be­tween yields on U.S. bonds and yields on for­eign bonds can only get so large be­cause of ar­bi­trage. So even as unin­spir­ing growth of 2 per­cent to 2.5 per­cent and an un­em­ploy­ment rate of just 5.8 per­cent in the U.S. would nor­mally lead to higher in­ter­est rates, they re­main ar­ti­fi­cially low due to out­side in­ter­fer­ence. For other as­set classes, the ef­fect of easy money is not so di­rect. Con­sider the case of oil prices. The sharp drop is be­ing char­ac­ter­ized (fairly, I might add) as a com­bi­na­tion of lower global de­mand and a siz­able pos­i­tive sup­ply shock. The surge in sup­ply, in turn, is be­ing at­trib­uted to im­prove­ments in tech­nol­ogy and in­fra­struc­ture, which have led to an en­ergy re­nais­sance in the U.S. So how is the Fed re­spon­si­ble for this spout of good for­tune for the U.S. econ­omy? Well, the rapid as­cen­sion of the en­ergy com­plex in the U.S. is the di­rect re­sult of easy money. En­ergy com­pa­nies through­out the coun­try have in­vested in equip­ment and new tech­nolo­gies us­ing money bor­rowed in the high-yield mar­kets. There­fore, the Fed has con­trib­uted greatly to the boom-and-bust cy­cle in the en­ergy mar­kets just as it con­trib­uted to the boom and bust in hous­ing.

When Fed hawks talk about "mar­ket dis­lo­ca­tions," this is what they are re­fer­ring to. Ac­cord­ing to a pa­per by Paolo Pasquar­iello of the Ross School of Business at the Univer­sity of Michi­gan, "dis­lo­ca­tions oc­cur when fi­nan­cial mar­kets, op­er­at­ing un­der stress­ful con­di­tions, ex­pe­ri­ence large, wide­spread as­set mis­pric­ings." When the Fed keeps in­ter­est rates this low for this long, as­set bub­bles are un­avoid­able. In­vestors will nat­u­rally seek to use bor­rowed money for profit if the op­por­tu­ni­ties present them­selves. Given the dearth of as­sets of­fer­ing ac­cept­able re­turns, in­vestors have lev­ered up and in­vested in as­sets rang­ing from com­modi­ties to high-yield bonds to stocks. In the process, prices on some of th­ese as­sets rose to un­sus­tain­able heights. We may now be see­ing the un­wind­ing of some of the spec­u­la­tive ex­cess.

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